Since the deregulation of lending rates in the mid-1990s, the Reserve Bank of India (RBI) has tried four different rate-setting mechanisms to provide consumers with the best lending rates. All these mechanisms so far have relied heavily on banks’ internal factors, like the cost of funds, to determine the lending rates. An internal committee set up by the RBI has now suggested linking bank lending rates with an external benchmark in a bid to increase transparency in the lending rate setting system by banks and quicken the monetary policy transmission.

The committee has also acknowledged that rate-setting systems like base rate and marginal cost of funds-based lending rates (MCLR) — benchmarks to which retail lending rates such like home loan and card loan rates are fixed — are not in sync with the global practices of pricing bank loans.

The committee, from 13 possible benchmarks, has recommended 3 –

• RBI’s repo rate

• Treasury bill rate

• CD (Certificate of Deposit) rate

These three market-linked benchmarks were selected because of their transparency, correlation with the policy rate and stability.

What led to external benchmarking?Banks may have been sluggish at times in passing off the benefits of policy rate cuts to customers in the forms of lower lending rates. For example, between April 2016, when the MCLR became operational, and October 2016 (pre-demonetisation), the repo rate was reduced by 50 basis points (bps) by the RBI but the 1-year median MCLR was reduced by only 15 bps. The RBI committee has pointed a finger at the high amount of discretion granted to banks under the base rate and MCLR systems for higher lending rates prevailing despite monetary policy going down.

What is base rate and why did it fail? The RBI adopted the base rate system in July 2010 aiming at improving the transparency of rate-setting mechanism and transmission of policy rates to borrowers. The base rate had to be calculated by each bank after adding their (i) cost of bank deposits (ii) negative carry on CRR and SLR (iii) unallocatable overhead cost (iv) average return on net worth. However, banks were allowed to use any other methodology for base rate calculation, provided the method was consistent and subject to review or scrutiny. This flexibility accorded to banks made most of them less sensitive to policy rate cuts.

Why is the RBI not convinced with the MCLR system? The failure of the base rate system made the RBI to switch over to MCLR-based rate setting system from April 1, 2016. Under this system, the banks were supposed to fix their interest rates on the basis of the latest rates offered by them on their new deposits. MCLR is calculated by adding (i) marginal cost of funds (ii) negative carry on CRR (iii) operating costs (iv) tenor premium. Unlike the base rate system, repo rate is factored in while calculating marginal cost of funds to ensure the transmission of policy rate changes. To enforce transparency, RBI directed banks to review and publish their MCLR every month and specify the interest reset dates while sanctioning the loans. To further bolster transmission, the maximum period between two reset dates was capped at 1 year.

Although the transmission of policy rates has been much faster than the earlier base rate system, the RBI has found it to be not fast enough to catch up with the policy rate cuts. The competition from other saving alternatives may have forced banks to keep their deposit rates high, resulting in higher MCLRs. While the fresh borrowers have still somewhat benefited from reduced policy rates, existing borrowers under MCLR system continued to pay higher interest rate due to longer reset periods. All these factors have resulted in lower than expected transmission of policy rates.

Challenges with external benchmarks: Now with the proposed new mechanism where an external benchmark may determine lending rates, the benefits of rate cuts are likely to be passed on to home loan borrowers much faster by banks. The RBI Study Group has also suggested quarterly resets of interest rates and full migration of all outstanding loans to the new benchmark by the end of March 2019 for effective transmission.

However, the use of RBI’s repo rate, T-Bill rate and CD rates as benchmarks will not be without challenges. The main concern with CD rates and T-Bills is their lack of market depth, which makes them susceptible to manipulation. As T-Bill rates also reflect fiscal risks, using them as benchmark may transmit such risks to the loan market. Similarly, CD rates are highly sensitive to credit cycles and liquidity conditions.

Repo rate would be a more effective benchmark as RBI directly controls it factoring in the prevalent macro-economic conditions and future outlook. However, as the study group indicated, linking repo rate with lending rate may constrain future changes in the monetary policy framework. Also, since these benchmarks are short-term in nature, it would be difficult for banks to price their long-term loans on the basis of these benchmarks.

Lastly, irrespective of the benchmark selected by the RBI, the final decision on pricing of loans would still rest with the bank. In this scenario, I think it would be best to let market forces play their part in enabling competitive pricing and innovation by the banks. In case, the central bank is unhappy with the pricing decisions by certain banks, it can choose to engage with them on a one-on-one basis.